The Blog

John Hussman: Fish Don’t Know They’re In Water (Investors In A Market Bubble)

We’ve just finished reading a great article by John Hussman at Hussman Funds called The Music Fades Out in which Hussman discusses current market conditions and provides a great illustration of the changes in investor psychology during market bubbles.

Here’s an excerpt from that article:

Fish don’t know they’re in water

A fish swims up to another fish and asks “How’s the water?” The other fish replies, “What the heck is water?”

The problem with financial bubbles is not that they are objectively difficult to recognize, but that they can only emerge if the majority of market participants become so immersed in them that they are willing to excuse or dismiss the extremes.

Intuitively, if overvaluation alone was always immediately followed by market losses, it would be impossible for the market to reach valuation extremes like 1929, 2000 and today, because the market advance would have been halted by much lesser overvaluation. Instead, periods of speculation can persist for some time, despite extraordinary valuations.

By the peak of every market bubble, investors come to imagine that historically reliable valuation measures are useless and no longer “work,” because they don’t understand how valuations work in the first place. As a consequence, they are repeatedly brutalized by the market collapses that follow.

At market extremes, investors become so impressed by the recent and glorious outcomes of their own speculation that they don’t even recognize the bubble surrounding them. After the bubble collapses, it becomes easier for investors to step back objectively, allowing them to conclude that the bubble was “obvious” in hindsight.

One of the best examples of this was July 2000, when the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” The article reflected on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.

Again, the only way to produce bubbles like 1929, 2000 and today is for speculation to continue despite lesser extremes. That doesn’t mean that valuations have failed. It means that speculation has persisted for longer than usual, and that the devastating consequences of hypervaluation are still ahead. Someone has to remain willing to say that out loud. The financial markets are in a bubble. It will end badly.

Given current valuations, even a return to average run-of-the-mill historical norms would result in a loss of about two-thirds of U.S. stock market capitalization. Meanwhile, any significant recession will likely be accompanied by a wave of corporate bankruptcies in a system where corporate debt is easily at the highest percentage of corporate gross value-added in history, and the median corporate credit rating is already just one notch above junk.

The likelihood of collapse will be smaller in periods when market internals are uniformly favorable across a very wide range of securities, because indiscriminate behavior is a hallmark of speculation. The likelihood of a collapse will increase dramatically in periods when market internals are weak or divergent, as they are now, because selectivity is a hallmark of growing risk-aversion.

The chart below shows our margin-adjusted CAPE, which now stands beyond even the 1929 and 2000 market peaks.